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Institutional Investors Bite off More Than They Can Chew in Their Quest for Better Returns

In the five years since the financial crisis struck, pension funds, endowments and other institutions have reacted by pouring money into overly conservative strategies on the one hand and complex alternatives on the other. Mistrustful of external managers, they’re adding to these challenges by doing more direct investing.

Sovereign wealth funds, endowments, pension plans --
across the board, institutional investors are rushing into
alternative asset classes to escape the purgatory of low
returns they expect from public markets over the next few
years. But a new report from State Street Corp.s Center
for Applied Research says these investors are failing to make
decisions that will help them meet their individual objectives,
manage risk and handle the greater portfolio complexity these
moves will bring. Irrespective of their stated goal,
institutional investors are exhibiting a herd mentality by
increasing their exposure to alternatives, says Suzanne
Duncan, the reports Boston-based author. While
there is nothing wrong with alternatives, whats worrisome
is that investors feel unprepared to handle the risks and
complexity.

Based on input from more than
3,000 financial industry participants in 60 countries,
including 200 face-to-face interviews with State Streets
applied research group, the report also highlights the tougher
environment that asset managers still face after the financial
crisis. From the 1980s to 2007, their growth seemed unstoppable
as institutions diversified out of conservative portfolios and
individuals socked away money for retirement. In the five years
since the crisis struck, though, retail investors have gotten
more conservative despite saying they need to be more
aggressive to reach their goals. Meanwhile, institutional
investors are adding hedge funds and other complex investments.
To stay competitive, asset managers must respond to these
wholesale changes.

Investors are no longer
acting in their own best interest, says Duncan. She
stresses that institutional investors of all stripes are
pursuing similar strategies regardless of their very different
aims.

In the U.S., 45 percent of
respondents said low interest rates have increased their desire
to add alternatives to their portfolios. In a separate State
Street online survey of 100 institutional investors, 56 percent
said they are boosting direct allocations to illiquid private
markets, including private real estate, private equity and
infrastructure. At the same time, when respondents were asked
about their biggest challenges, the complexity stemming
from increased investments in alternatives ranked No.
1.

Duncan says investors
moves to plow money directly into certain strategies without
using external money managers reflects disillusionment with the
value theyre getting from intermediaries relative to the
fees they are paying. Theyre looking to take
matters into their own hands much more aggressively than in the
past, she explains. They are being driven by
artificially high expectations of future returns.

On average, the expected
market return for defined benefit and defined contribution
pension plans is 8 percent, which most experts agree is
wildly optimistic. To support their direct investing efforts,
institutional investors are on a hiring spree.

To combat investors
mistrust and poor decision making, Duncan says, asset
managers should personalize performance reporting so
its a better match with clients goals. Most
performance is now reported relative to peers or commonly
used benchmarks such as the Standard & Poors 500
Index. We need to overcome trying to outperform a
benchmark that might be meaningless to a client and quit
attempting to compare ourselves against our peer group,
Duncan says.

Robert White, executive
director and portfolio manager with J.P. Morgan Asset
Managements global multiasset group in New York, says
the firm uses customized benchmarks to help investors analyze
its performance over short time periods or to pinpoint the
value a manager is adding. Such benchmarks make sense for,
say, an endowment aiming for a real rate of return of 5
percent over inflation.

Comparing a managers performance to peers or
to a standard index wouldnt help the endowment analyze
whether it was on its way to meeting its goal, White
says. He adds that customized benchmarks are especially
useful for more-open-ended mandates, such as when a pension
fund outsources a portion of its portfolio to J.P. Morgan,
giving the firm freedom to invest where it sees the best
opportunities. Its a better way to judge
success, White maintains. An
investors objective could be to manage volatility,
protect on the downside or speed the time to close a funding
gap.

With global infrastructure needs projected to top $50 trillion through 2030, urban expansion is creating important new investment opportunities. In The Wealth of Cities, a special report from Prudential Investment Management, we analyze the four key investment sectors created by this prime time of urbanization.